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Econ 474: What's a tax credit?

by Matthew DeBord

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A sign in Maui, Hawaii, urges people to buy before the $8,000 tax credit expires. Both individuals and businesses can get credits. Chris Arnold/NPR

Yesterday, I wrote a post about how Louisiana is offering aggressive tax credits to the gaming and software industries in an effort to lure them to what I dubbed "Silicon Bayou." Louisiana, along with many other states, offers tax credits to encourage business activity and relocation.

But how do tax credits work?

There are basically two types of tax credit: refundable and non-refundable. The latter can lower a business' tax bill to zero, but not turn into a cash refund if the amount takes a tax liability lower than zero. The former can result in a check being cut by the state or IRS, as a refund.

This can work about particularly well if a company is eligible for a tax credit and is losing money — as several producers of pulp, the raw material that goes into paper, learned in 2009, when big companies such International Paper received billions from the Treasury for exploiting a credit that was originally aimed at encouraging alternative-fuel use. A byproduct of pulpmaking is something called "black liquor," which paper mills have for a very long time cycled back into their systems and burned to provide power.

Because it's "biomass," black liquor-burning qualified for the tax credit. And it turned money-bleeding companies in 2009 into money-minting investments in the following years, until the tax credit was killed.

Tax credits serve two purposes, one arguably more important than the other, especially at the state level. They encourage business activity by removing some financial and tax risk from operations (they do this at the personal level as well — individuals can get tax credits for taking out a mortgage or having kids).

But they also advertise that a state is "business friendly." This is what Louisiana is up to, with its new digital media credits, which fall into two generous categories: 25 percent for stuff related to producing, for example, video games; and 35 percent on payrolls for the people who do the producing.

The problem with tax credits for business are pretty obvious: you take money out of the state's revenues in order to encourage the kind of economic activity that, in theory, will more than make up for it, but that doesn't always pan out. Tax credits are a trade-off. But for states that want to lure businesses, they can be very useful.

Previously in The Breakdown

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